Importance of Dividends

January 2nd, 2014

By: Philip Weiss

It’s well-known that dividend-paying stocks can be an important part of retiree portfolios. These stocks can provide cash flow for income needs while giving retirees the opportunity to hold investments that will grow in value.

But dividends can play an important role in the portfolios of other types of clients, too. First, they often are an important component of any portfolio’s overall investment return, especially at a time when stocks are not appreciating strongly. In addition, for those who are still working, the cash provided by dividends can be reinvested to buy more shares of the same security or applied toward the purchase of other securities. This means they can compound the growth of a portfolio.

Dividend-paying stocks can provide advantages relative to bonds. Bonds provide a fixed return over their lives. For example, holding a 10-year, $1,000 bond paying a 5% coupon to maturity entitles the holder to $50 per year while holding the bond. At the end of 10 years, the principal is repaid, too (unless the bond issuer is in financial trouble).

On the other hand, buying a stock yielding 3% that is forecast to grow by 7% annually could translate to a dividend yield of about 6% by the end of the same period, based on the amount you originally invested in the stock. If the dividend increases by 10% per year, the dividend in year 10 will represent roughly 7.8% of the original investment.

Hopefully, the share price will increase as well, meaning the total return during the holding period will be even greater.

Here’s more good news. Studies have shown that dividend-paying stocks can lessen the effects of portfolio losses during bear markets, as the income they provide can offset some of the losses that result from a lower share price. In addition, stocks paying a secure dividend are typically less volatile because the dividend can provide a “floor” value for the stock, especially in times of uncertainty. Reinvestment of dividends can also significantly reduce the amount of time it takes to recoup losses suffered during market declines.

Dividends can also play a meaningful role in retirement planning, particularly over time because they may grow at a greater rate than inflation (unlike fixed-income investments or annuities).

Your dividend-paying portfolio can serve as a passive source of income to supplement (or, perhaps, for some even replace) your pension or retirement savings and may even allow you to retire earlier than would otherwise have been possible.

While it has been shown that reinvesting dividends can have a major impact on portfolio value, once your portfolio has generated significant gains, you may decide to not reinvest your dividends. Instead you can use them as a source of current income.

Another interesting use of dividends is to give retirees flexibility when they are withdrawing money from their portfolios. To the extent a portfolio does not generate enough cash to fund any withdrawals, BWFA will have to sell securities.

Selling shares has tax implications, and BWFA might have to sell securities at an inopportune time. Instead, cash generated by income-producing stocks can help fund those distributions, minimize the need to recognize gain or loss on stock sales, and enable the advisor to sell securities based on market factors rather than individual needs.

A final thought. There’s an old investing adage, “Profits are a matter of opinion; dividends are a matter of fact.”

In other words, dividends are paid from real earnings and in “hard” dollars – they cannot be manipulated by creative accounting. A dollar paid out to an investor as a dividend is a dollar that is no longer under company control.

Companies that are able to pay a steadily increasing dividend tend to be disciplined and efficient in their capital allocation and cash flow management—just the types of companies we look for on behalf of BWFA clients.

Dividend-Paying Stocks Are Strong Performers

Many studies have shown that higher-yielding stocks outperform the overall market. Wharton’s Jeremy Siegel showed that over a five-decade period from 1959-2011, a large basket of dividend stocks outperformed the market by roughly 2.6% annually.

While this figure may not sound that meaningful, over a long period, that difference adds up to a huge amount. Siegel’s study showed the highest-yielding dividend stocks turned a $1,000 investment into $609,000, when those dividends were reinvested annually; a similar investment in the S&P 500 would have appreciated to only $173,000.

The above chart illustrates the Total Return of the S&P 500 with dividends reinvested (orange dotted line) and Total Return of the index without dividends reinvested (white solid line). The bar chart at the bottom illustrates the number of S&P points that were added to the index through dividends in each month of the 10-year sample. As it happens, the Total Return with Dividends Reinvested was 99.2% vs. 62.4% if they were not reinvested during the period.